Wicksell at the Bank of Canada

Q ED Queen’s Economics Department Working Paper No. 1087 Wicksell at the Bank of Canada Kevin Clinton Queen’s University Department of Economics Queen’s University 94 University Avenue Kingston, Ontario, Canada K7L 3N6 6-2006 Wicksell at the Bank of Canada Kevin Clinton Department of Economics Queen’s University June 2006 JEL classification: E42; E52; E58. Keywords: Wicksell; central bank; monetary policy; Bank of Canada. I gratefully acknowledge comments on earlier drafts from Pierre Duguay, Emmanuel Carré, Charles Freedman, David Laidler, Marc Lavoie, John Murray, Tom Rymes, and Michael Woodford. The views in the paper are mine alone. Although I worked at the bank for many years, the paper has no insider revelations; the discussion relies entirely on published material. [email protected] Wicksell at the Bank of Canada Kevin Clinton ABSTRACT Wicksell, writing around the start of the 20 th century, outlined an approach to monetary policy strikingly similar to the modern approach, of which the Bank of Canada has been a pioneer. Its features include: the overriding objective of price stability (or low inflation); an interest rate instrument controlled by the rates on settlement balances at the central bank; and a policy rule under which the instrument varies in response to deviations from the objective. Wicksell’s natural rate of interest has resurfaced as the neutral rate in mainstream macroeconomic models; and his description of the inflation process has parallels in the modern Phillips curve. Moreover, in a mandate for price stability, one can find a logical basis for the independence and accountability of central banks. The paper tries to explain why Wicksell’s ideas fell by the wayside for a century, and describes how the Bank of Canada, by pragmatic steps in the 1990s, helped reinvent Wicksell, and install a neo-Wicksellian monetary policy. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly supposed Indeed the world is ruled by little else … Not indeed immediately, but after a certain interval. John Maynard Keynes, 1936 The General Theory of Employment Interest and Money 1. Introduction This paper highlights striking similarities between modern monetary policy and the writings of Knut Wicksell, 100 years ago. 1 It relates, in particular, how the Bank of Canada adopted a neo-Wicksellian approach to monetary policy. Since the bank led the way for many other central banks, and since the approach has had wide success, the story has broad, international relevance. Anyone following monetary policy will be familiar with the main features of the modern regime. The remarkable parallels with Wicksell are indicated in the following table. 1 Woodford (2003) also draws out these similarities. Woodford takes the theory much further, using inter- temporal optimization and rational expectations. - 2 - Monetary policy parallels Conduct Wicksell Modern or neo-Wicksellian Objective stable price level low inflation or price stability Canada: 2% target Instrument commercial bank interest rate short-term interbank rate Canada: overnight rate Implementation keystone central bank discount and central bank discount rate and deposit rates deposit rate Canada: bank rate and deposit rate Policy rule adjust interest rate in response adjust interest rate in response to actual deviations from to actual and anticipated objective deviations from objective System Banking pure credit system—no bank zero reserve requirement reserves Axis of monetary commercial bank rate relative short-term rate relative to transmission mechanism to natural (neutral) interest natural (neutral) interest rate rate Inflation/deflation gap unobservable gap between unobservable gap between demand and potential output demand and potential output Wicksell published Interest and Prices , his most comprehensive statement on monetary policy, in 1898. 2 With the possible exception of the Swedish Riksbank in the 1930s, no central bank has deliberately used this work to design a policy regime. Yet by pragmatic steps, central bankers adopted a set of measures that they could have found in Wicksell. At the Bank of Canada, John Crow, then a new Governor, announced a commitment to price stability in 1988. Reserve requirements were phased out in the early 1990s. The bank adopted the overnight interest rate as policy instrument in 1994, and revamped its operating framework for controlling this rate around the rates on settlement accounts in 1999. The stepwise installation of Wicksell was complete by the end of the century. Many other central banks adopted similar measures at about the same time. The story in the paper starts, in section 2, by trying to explain why the Wicksellian approach, which would have conceivably avoided the disastrous monetary policy mistakes of the 20 th century, fell by the wayside for so long. The conclusion is that this was just bad luck—accidents of country, language and of competing monetary doctrines. Section 3 describes the extent to which Wicksell anticipated the broad outline, and many if not all key details, of the current monetary policy model. Advances in economic science may have modified components, but the structure remains intact. Section 4 looks at several issues that preoccupied Wicksell—business cycles, the Quantity Theory of Money, price indexes, countercyclical monetary policy—and which provide a sidelight on the evolution of thinking. Section 5 is about the framework for the conduct of 2 The Wicksell items in the table are all from this book, except the third, which is in a 1917 essay. - 3 - policy—the definition of central bank responsibility, and of the price stability objective, and the mechanism for interest rate control—focusing on the Bank of Canada in the 1990s. Concluding thoughts are in section 6. 2. One hundred years of solitude Puzzling loss—and reinvention The sentences omitted, in the passage from Keynes at the top, famously go: “Practical men, who believe themselves to be quite exempt from any intellectual influences are usually the slaves of some defunct economist … some academic scribbler of few years back.” These playful lines do not help at all for understanding the disappearance and reinvention of Wicksell’s monetary policy. First, there are a lot more than a few years to explain. Second, Wicksell was never defunct. He was the founder of the Swedish school of economics, and recognized internationally by peers in his own and following generations for contributions in various fields of economics.3 Nor was he a mere scribbler. He wrote clearly and concisely, and is still readable today. He was among the first to use the term monetary policy . He was notorious in Sweden for his radicalism.4 Although this may not have helped his credibility in central banking circles, Wicksell’s influence was evident in the Riksbank’s adoption of a price stability goal in the 1930s—which, given the circumstances, went relatively well (Jonung, 1979). Third, many central bankers acknowledge intellectual influences. Every Governor of the Bank of Canada has had a keen interest in economics; the bank speaks proudly of its intellectual assets; and it has long cultivated academic connections. More to the point, many bank veterans have been aware of Wicksell, and at least one actually read Interest and Prices . Despite this familiarity, there was no conscious reference to the original author as the bank groped towards a neo-Wicksellian regime in the 1990s. Other central banks, under similar circumstances, followed the same path, at about the same time. 5 In the 1990s, the practitioners, often borrowing from each other, assembled a new paradigm for monetary policy, unconscious that they were reinventing Wicksell. Outrageous fortune 3 The Swedish school included Karl Gustav Cassel, Bertil Ohlin and Gunnar Myrdal. Outside Sweden, Lionel Robbins and James Buchanan acknowledged Wicksell’s influence (biographies in The Concise Encyclopedia of Economics .) Since the 1960s, David Laidler and Axel Leijonhufvud have been his main torch bearers. 4 A Malthusian, his forecasts for the economy and population in the 20 th century were as gloomy as they were wrong (Part V, Selected Essays ). Wicksell worried about sex and alcohol and the working class; he was an advocate of birth control. The latter does not shock any more, but it is startling to read, first, that Sweden was on the verge of overpopulation in the early 1900s, and, second, that the solution was emigration to Siberia, of all places (pp 160-1). In 1910 he spent 2 months in jail for a satire on the Immaculate Conception. Wicksell’s foibles in no way diminish the man; rather they reflect his intellectual honesty and courage. 5 For example, Alan Blinder, former Vice-Chairman of the Federal Reserve Board, cites Wicksell once, for the idea of a neutral interest rate (Blinder, 1998). - 4 - What accounts for the loss of Wicksell’s monetary policy for so long? A large part of the explanation—there may be no other—lies in intertwined accidents of geography, language, and intellectual history. The successful experiment in Sweden in the 1930s did not make the waves that an application in a large economy might have done. Wicksell wrote mainly in German and Swedish. He published only a couple of articles in English, which may be the necessary language to establish a big new idea in political economy. As for intellectual history, Wicksell’s ideas had to compete with 2 potent alternatives, Keynesianism and monetarism, as well as their extraordinarily persuasive advocates. The English translation of Interest and Prices appeared—10 years after the author’s death—in 1936. Could timing be worse? Keynes was grabbing all the attention—and did so for decades to come. The post-World War II consensus, among economists and central bankers alike, downgraded the effectiveness of monetary policy, and assumed that it should share responsibility (as a junior partner) with fiscal policy, for a comprehensive list of macroeconomic goals.

Load more